Explain the different steps in advertising for bank or financial services institutions

 Several steps are essential for successful execution of advertising campaigns in financial services.

Determining the Objectives of Advertising:

The first step is to determine the objectives of the advertising campaign, reflecting the overall marketing strategy of the company.

For example, the objective of an advertising campaign might be to generate new policies for an insurance product or to increase the level of consumer awareness of the brand or the company. Recognizing and identifying the exact objective of an ad campaign is critical to accurate assessment of its merits and potential. Examples of popular advertising objectives in financial services are target levels for customer inquiries, new policies signed, and advertising recall.

(2) Determining the available Budget

The next step in the advertising process is to determine the budget required to carry out the ad campaign. Often, the required budget is significantly different from what is available, and may be dictated by organizational budgetary constraints. For example, the budget available for advertising a particular financial service might be determined based on a percentage of the total premium revenues generated in the prior year. Clearly, an increase in the intensity of an advertising campaign would require higher budget allocations and may call for the abandoning of traditional budget-setting approaches for advertising. The total budget that is required to execute an advertising campaign is a function of the reach and frequency (and hence the gross rating points) necessary to create consumer response and the cost of media used to secure this level of exposure. The associated dollar figure, therefore, needs to have been estimated prior to negotiations with higher levels of management, in order to ensure the availability of sufficient funds for executing an effective advertising campaign.

(3) Estimating the Return on Investment (ROI):

The next step in the advertising process is to determine the return on investments associated with the advertising campaign. Four items of information are needed in order to conduct this estimation, one of which is an estimate of the lifetime value of an acquired customer. The lifetime value of the customer is the total profit that an acquired customer represents to the company. It is quantified as the sum of the profits associated with the stream of transactions that the customer will undertake with the company over the years. In addition, an estimate of the total number of consumers who will be exposed to the advertising campaign is required. An estimate of the percentage of reached consumers who will eventually purchase the advertised financial product or service is also required.  Clearly, negative return on investment estimates would make the advertising campaign and unlikely prospect for further action.

(4) Developing the Contents of the Ad:

Once the return on investment computation has shown favorable results, the next step in the advertising process is to develop the contents of the ad, as reflected in its execution style and informational content. In this step, the services of advertising agencies that specialize in producing financial services ads are required. These specialized agencies often also engage the support of legal experts who can determine the compliance of advertising content with existing regulations. Often, testing of ad content using small-scale samples, focus groups, or test markets may be needed.

(5) Media Selection:

The next step in the advertising process is to determine the media that will be used. In general, financial services that are more complex and require the communication of detailed information tend to rely on print forms of advertising.

Television advertising, which capitalizes on multiple sensory inputs, tends to be the most effective although often the most expensive. Once the media to be used for an ad campaign has been determined by the ad agency, a media schedule needs to be developed in order to achieve the original objectives of the ad campaign which had been identified. There are specific media scheduling and campaign execution strategies that are most effective in certain forms of financial services. For example, an effective ad-scheduling tactic is to advertise in pulses with heavy advertising in one month, reduced advertising the following month, and a return to high advertising levels in the third month.

(6) Scheduling and Campaign Execution:

There are specific media scheduling and campaign execution strategies that are most effective in certain forms of financial services. For example, an effective ad-scheduling tactic is to advertise in pulses with heavy advertising in one month, reduced advertising the following month, and a return to high advertising levels in the third month.

This tactic tends to result in more sales and higher levels of consumer response than a constant and steady level of ad spending.

(7) Measurement:

The final step in the advertising process is to assess the impact of the ad campaign through formal market research or examination of company records. It is critical to measure and record sales levels and other advertising responses following an ad campaign in order to determine the financial effects of the invested advertising dollars.

Such measures may help fine-tune the advertising strategy of the company and provide estimates for optimizing future advertising campaigns. For direct advertising campaigns, such measures are obtained through the tracking of consumer inquiries following the ad campaign and the use of tracking numbers, which can pinpoint the exact promotional material to which the consumers are reacting. For ads delivered through mass media such as television, radio, and newspapers, the tracking of consumer responses may be considerably more difficult and might require examining aggregate changes in sales for the months following the ad campaign, or the purchase of market research data from specialized research firms.

National Macroeconomic Goals

 In considering macroeconomic ‘good’ and ‘bad,’ consumption and investment expenditure are clearly in the ‘good’ column. Equally clearly, unemployment and inflation are in the ‘bad’ column. But other ‘goods’ and ‘bads’ exist which are less clear. Some amount of government expentiture is clearly good; government must at a minimum establish the rule of law, and deal with market failures such as public goods and externalities. However, a large spending defecit is generally considered a ‘bad.’ International trade is also generally a ‘good’ because it permits higher living standards than would be possible in a closed economy. However, it is not clear what the ideal balanace of trade would be. Would you prefer X>Z, a sign of strength like Japan or Germany, or Z>X, a higher use of foreign resources? Or would you prefer to maintain X=Z, resulting in a stable currency on foreign exchange markets?

 Having identified all the ‘good’ and ‘bad’ goals, we must now weight them. Since many of the ‘goods’ and ‘bads’ are interrelated, this will probably involve trade-offs. A political party’s election platform is an attempt to specify the weightings and tradeoffs considered most desirable. Consider the following ‘welfare function’ where W is national welfare (similar to individual utility from microeconomics):

 W = C^0.6I^0.2G^0.2 –U² –INF³ – 10|G-T|

 This states that C, I and G are all ‘good’ but the optimum distribution between them is 60% C, 20% I and 20% G; that unemployment is a ‘bad’ but inflation is worse, and that an unbalanced budget is a ‘bad’ no matter which direction it is unbalanced. To maximize W, the naïve answer is to make GNP as large as possible, allocate GNP among C, I and G in 3/1/1 ratio, have a zero unemployment rate, a zero inflation rate and a balanced budget. This interpretation is naïve because a zero unemployment rate is not possible, and U and INF are interdependent; some difficult calculations must be performed to determine the optimal rate of both U and INF on a given Phillips curve (assuming you believe a Phillips curve exists). The trade-off is also not simply between U and INF. The higher U, the lower GNP, hence the lower C, I and G as well. And whatever actions you take may result in an unbalanced budget, with its own effect on the equation. Balancing the budget is, for all the obvious reasons, neither simple nor easy.

 Also, strange interactions may exist that are not obvious at first. Suppose a balanced budget is a priority and the only apparent way to achieve this is to raise taxes. Some economists believe in the Laffer Curve:

  Laffer’s argument is that if the income tax rate were 100%, nobody would be willing to work since all wages and salaries would go in taxes; government tax revenue would therefore be zero. As tax rates decreased, some people would begin to work and tax revenues would increase, to some maximum at some point; below that point, decreasing tax rates would begin to result in decreased revenues, again reaching zero when the tax rate is zero. Some tax rate X exists where maximum revenue is achieved. If the government is already taxing at this rate, any change, positive or negative will result in reduced revenues. Moreover, if the government is already taxing above this rate, an increase in tax rates will be accompanied by a decrease in revenues; the budget-balancing action in this case would be to reduce tax rates. Hence Reaganomics and ‘voodoo economics.’ If you believe in the Laffer curve, then any increase or decrease in the tax rate must be based on a good estimate of where the economy is currently positioned.

 Another problem is that if you are trying to maximize the sum of national welfare across a span of years, then maximizing welfare this year might not be the correct approach; some less-than-maximal value for W this year might lead to the potential for higher values for W in future years than would otherwise have been possible.

 Different political parties believe in different national welfare functions; the items in these functions are generally similar but the weightings are radically different. Evidence suggests that the state of an economy is a major factor in deciding which party gets elected, and as a result elected governments may enact policies to ‘solve’ economic problems in election years, regardless of what problems may be caused down the road.

The Keynesian Theory of Money

 Where the quantity theory treats money exclusively as a medium of exchange, they Keynesian theory stresses that money serves other functions as well. There are three types of demand for money balances:

·         The transactions demand,  which arises from the fact that people need money to finance current transactions. Households and firms hold money balances to bridge the gap between the reciept of income and its expenditure. The amount of money held for such purposes will be closely related to the level of national income. However, it is also likely to be influenced by the rate of interest. If the rate of interest is high, there will be a strong motive to avoid holding money and instead hold interest bearing assets.

·         The precautionary demand, which consists of money to be held to meet the sudden arrival of unforseen circumstances. Again, the main factor likely to influence this amount is the level of income, though again high interest rates will tend to push money out of this category.

·         The speculative demand, which emphasizes the use of money as a store of wealth rather than a medium of exchange. Holding money has an opportunity cost: The income or utility foregone on the investments or goods the money could have bought. Therefore it would seem that households and firms ought immediately to invest or spend all money above that required for transactional and precautionary needs. However, in the presence of uncertainty, individuals or firms will sometimes believe that the returns available in the future might be sufficiently better than the returns available today that it is worth waiting.

 The speculative demand bears further analysis. While there will be speculation on all goods and services whose price can change with time, the speculative demand is particularly interesting in the market for government bonds. If households and firms believe the price of bonds will fall in the near future, they will be likely to sell their current holdings of bonds and to defer purchasing new bonds until the price drop has taken place. These actions increase the supply and reduce the demand for bonds on the open market, which will have the effect of lowering their price. Under this situation, the speculative demand for money will be high as households and firms will wish to hold money in anticipation of the price drop. Conversely, if households and firms expect bond prices to rise, then they will defer selling bonds now and, if they have money available, will tend to want to buy bonds. This will decrease the supply and increase the demand for bonds, driving prices up; and the speculative demand for money will be low, because speculative monies will tend to be invested in bonds.

 The price of government bonds and the interest rate are inversely and tightly related. Suppose that an individual is considering the purchase of a government bond which pays $10 per annum. The bond will not be worth buying unless it returns at least the current rate of interest. If the current rate of interest is 10%, then the bond is worth buying only if it costs $100 or less. If the current rate of interest is 15%, then the bond is only worth buying at $66.67 because this is the amount over which $10/year represents a 15% return. In a competitive market, sellers will not be willing to sell at less than the ‘going rate’ so bond prices will be very closely pegged to the price at which they provide a return equal to the currently prevailing rate of interest. (Or: The interest rate is the return on government bonds; the more you have to pay for them, the less return you’re getting.)

 We have established that the speculative demand for money varies based on the expected changes in bond prices. If bond prices are expected to fall, the demand will be high, and vice versa. Since bond prices vary inversely with the interest rate, if the interest rate is expected to rise, the speculative demand for money will be high, and vice versa. It is reasonable to suppose that when the interest rate is quite low, most people will expect it to rise; and when it is quite high, most people will expect it to fall. Therefore, the speculative demand for money varies inversely with the currently prevailing interest rate. If the interest rate is low, then the expectation will be that it will rise, which means that bond prices will fall, which means people would rather hold onto their money so they can buy the cheap bonds later, so the speculative demand for money will be high; and vice versa through the whole process.

 Considering all three types of demand for money, it follows that the overall demand for money balances will vary directly with the level of income and inversely with the rate of interest. Higher (lower) Y means more (less) money held in transactional and precautionary balances. Higher (lower) interest rates mean more (less) incentive to reduce money balances so as to take advantage of investment returns, and also more (less) incentive to purchase government bonds with money otherwise held in speculative balances. For a given Y, the relationship between the demand for money and the rate of interest is called the ‘liquidity preference schedule’ which looks like this:

  

The point on the demand curve that intersects with the (vertical) money supply curve will determine the equilibrium rate of interest. M_T+P represents the amount of money held for transactional and precautionary purposes, which for our purposes is assumed to vary only with Y. Since Y is held constant here, M_T+P is a vertical line: At all rates of interest, the same amount of money is held. The speculative demand for money is a function of the rate of interest, reflected in the sloped portion of the demand curve. However, once a sufficiently low interest rate is reached, the curve becomes horizontal. This reflects the observation that at very low interest rates, households and firms are simply not interested in buying any more bonds. For one thing, the interest rate is so low that everyone is convinced it should rise soon, so nobody will want to invest in current, low-yield bonds. Once this point has been reached, further increases in the money supply will simply find their way to idle balances and further reductions in the interest rate will not occur.

 The Keynesian theory of money, unlike the quntity theory, suggests that changes in the money supply do not lead directly to changes in aggregate demand. Instead, monetary policy affects interest rates, thus indirectly influencing those components of aggregate demand which are sensitive to interest rates. Note that we can conclude from this that the graph above is inadequate to explain the final equilibrium interest rate. The graph above is for a fixed value of Y. But a change in interest rates (at least along the sloped portion of the curve) will result in a change in Y. So the initial equilibrium shown by the graph above cannot be the final value. This will be analyzed in detail later.

 It is also highly noteworthy that Keynesian theory suggests that monetary policy will be ineffective in dealing with a deep recession. When the rate of interest is so low that the liquidity schedule is operating on the horizontal portion of the curve, the government can expand the money supply until it turns purple and no further reductions in interest rate—and therefore no further effect on aggregate demand—will be forthcoming. Keynes suggested that in a deep recession, with substantial spare capacity and pessimistic business expectations, extremely low interest rates would be necessary to stimulate investment, but these rates might be below the minimum to which monetary policy can force the rate. This is the famous ‘Keynesian liquidity trap.’

Money

 The models so far have not included the concept of money. This is unsatisfactory because money clearly plays a part in economics. A complete macroeconomics theory must be capable of explaining the historical behavior of the price level. In addition, money may have an importance beyond the simple measure of prices, because monetary factors may influence “real” values such as output, income and employment.

 Money is anything which is generally acceptable for the settlement of debts. Money does not have to be created by a central authority. In prison, cigarettes can become money simply because they are an acceptable medium of exchange. In many economies the most important source of money is commercial bank deposits. Bank deposits are money because they are generally acceptable for the settlement of debts, rather than through any legal or ‘official’ authority. ‘Legal tender’ is money which has been legally protected such that the refusal to accept it for the settlement of a debt is illegal. Even though bank deposits are not legal tender, many people find a check drawn on a bank deposit account acceptable as a form of money.

 There are three forms of money:

·         Coins

·         Notes

·         Bank deposits

 Money has three functions:

·         A medium of exchange: Without money, goods and services could only be traded through bartering, which is wasteful and difficult, particularly in a highly specialized modern economy. Money is used as a universally acceptable barter substitute. To be useful for this purpose, money must posess the following characteristics:

-          it must be widely acceptable;

-          it must have a high value to weight ratio;

-          it must be divisible to settle debts of differing values;

-          it must be difficult to reproduce, counterfeit or debase in value.

·         A unit of account or measure of value: Money provides a standard by which the value of any good or service can be measured. If a car costs $25,000 and a hamburger costs $2, then a car is worth, and can be exchanged for, 12,500 hamburgers.

·         A store of wealth: A household (or firm) can sell its factor services or goods for money, and then keep the money until it has decided what to do with it. Almost every household and firm holds some amount of money. To act as a satisfactory store of wealth, the value of money must be reasonably stable over time.

Circular Flow of Income

 In order to develop a simple short-run model of the economy, we make the following assumptions:

·         That technical knowledge and resources are fixed in the short run

·         That there is a fixed relationship between output and employment

·         There is no international trade

·         There is no government sector; ie there are no taxes and no government expenditure

·         Firms distribute all profit to their owners (households) immediately when it is earned

·         All investment is carried out by firms

·         All prices are constant, so that any change in numeric GNP is caused by a change in real GNP.

 

Firms produce all consumption goods and services, which are purchased by households. Households own all factors of production (resources) – labor, land, capital goods, etc. – as well as the firms themselves. This results in a circular flow of income.

 The national output (GNP) is the flow of all final goods and services in an economy within a given period. The Net National Product (NNP) is GNP less depreciation, or in other words the level of output above and beyond that which would be required simply to maintain the existing stock of capital goods. In calculating GNP and NNP, only final goods and services are included. Intermediate goods, which is to say goods that are used in the production of other goods, are not included, because otherwise double-counting would occur.

 GNP can be calculated in three different ways:

·         By finding the total expenditure on final goods and services

·         By finding the value added by each producer

·         By finding the total income earned by each factor of production

 In practice, it can be quite difficult to make the determination between final and intermediate goods. The second method may be easier because it only requires knowing the value of output and the value of factor inputs for each firm in the economy. The final method is perhaps the easiest, since it is a simple sum of all household incomes.

 Inputs to production include primary factors and intermediate goods. Intermediate goods are those factor inputs that were produced in the current period. All other inputs used in the current period are primary factors. Labor input is a primary factor, as are (most) buildings and machinery. The income paid to owners of primary factors must be financed by a firm’s sales and are normally classified as:

·         Wages and salaries – paid in exchange for the use of labor services

·         Rent – paid in return for the use of land and capital goods not owned by the producer

·         Interest – paid to the households who have loaned money to purchase land and capital

·         Gross profits – residual money accruing to the firm after payment has been made to all other factors, usually distributed in the form of dividends to the households that own the firm

 The sum of payments by a firm for primary factors and intermediate goods will equal the firm’s receipts from sales. As a result, the value added by the firm is equal to the sum of payments to primary factors, because this will equal sales (total value of production) less payments to intermediate goods (value that came from somewhere else). Since GNP equals the sum of producers’ value added, GNP is also equal to the sum of producers’ payments to primary factors of production (GNP=GNI).

 The equivalency between GNP and GNI depends on the definition of profits as a residual amount obtained after deducting the value of all other inputs to production; and on the assumption that all profits are immediately distributed to households. In the real world, these assumptions may not hold.

 Given that GNP=GNI, it follows that the income received by households must be just sufficient to purchase all output produced by the economy. It would seem that by the act of establishing a firm and producing output, sufficient income must thereby be produced so that the firm’s output can be paid for. While this is true, it is not guaranteed that this new income will result in effective demand for the firm’s goods. Some income might not find its way into expenditure at all, at least in the short run.

 The level of output that can be sustained is therefore dependent on the level of expenditure or effective demand. Potential output sets the limit to the level of income and expenditure possible, but actual output may fall short of this limit. The short run theory of income determination sees acual output as dependent on effective (aggregate) demand.

 Households engage in two activities, consumption and savings. Consumption (C) consists of expenditure on goods and services to satisfy current needs or wants. For the purpose of this simple model, we shall ignore the problems raised by consumer durables (like cars), which yield a flow of services over time. Savings (S) is whatever income is left over after C. It follows that gross national income (GNE aka Y) = C+S.

 Firms also engage in two activities, investment and production. Production occurs to satisfy the consumption demand of households and is in equilibrium only when it is equal to that expenditure, so it is also represented by the symbol C. Investment is the production of goods and services which are not used for consumption purposes. There are two main categories of investment: Inventory and capital goods. Buildup of unsold inventory is a form of investment; reduction in inventory is a form of disinvestment. Some investment in capital goods is required just to maintain current levels of production, but additional investment over and above this amount will result in increased productive capacity in the future. Investment expenditure is given the symbol I. Total output will equal C+I. Total output is GNP, which is equal to Y, so: Y=C+I.

 If Y=C+I and Y=C+S it follows that I=S. Investment and savings are defined in such a way that they must be equal. This does not mean that planned saving always equals planned investment; quite the contrary. However, by the definitions of the model, actual savings is the amount of money that will be available for acual investment and thus the two will be equal. If planned investment is lower or higher than planned savings, firms will find themselves encountering an unplanned investment or disinvestment.

 If all income were consumed, then all value added (output) would accrue to private households through factor incomes, and all factor incomes would be used by households to purchase consumption goods and services from firms. In such an economy, supply would create its own demand, as all income would be consumed. There would be no withdrawals or injections to the circular flow of income, so that any flow of national income would continue in an indefinite equilibrium, with no tendency for GNP (or GNI or GNE) to change. This of course assumes a fixed capacity output, but this is a short-run model. In reality, if all income were to be consumed, the stock of capital goods would decline and output would be reduced.

 In practice, most economies save and invest a proportion of national income, as shown in the diagram above. Savings are not passed on in the circular flow of income, but constitute a withdrawal from it. In other words, savings do not constitute a component of aggregate demand, because the act of saving does not generate a demand for current output. Investment, on the other hand, is an injection into the circular flow of income. It is part of aggregate demand because the act of investing (buying more capital goods) does indeed generate a demand for current output.

 Any withdrawal has a contractionary effect on the level of national income. Any injection has an expansionary effect. Equilibrium can only occur when the contractionary and expansionary effects are in balance, or in other words when there is consistency between the savings plans of households and the investment plans of firms. If planned savings and planned investments are equal, the economy will be in equilibrium. If they are not equal, the economy will be in disequilibrium and must expand or contract until the plans again come into balance. In the equilibrium diagram above, households elect to save 10% their income. If households change their plans and choose to save twice that amount (20%) then the economy will be in a contractionary disequilibrium:

 Under these conditions, and if there are no changes to the planss of investors or savers, national income will fall. In the earlier, equilibrium model, aggregate demand (Y) was equal to $100 billion, equal to C ($90 bln) + I ($10 bln). Now, C has fallen to $80 billion with I unchanged at $10 billion, resulting in aggregate demand (Y) or $90 billion. The sales reciepts of firms will have fallen accordingly. As a result, firms will not be able to sell all the output produced, so there will be an unplanned increase in inventories. Inventories will continue to increase so long as output is maintained at the original level. Soon, firms will react by reducing the level of output. Assuming that firms  continue to plan to invest $10 billion, and households continue to plan to invest 20% of their income, a new equilibrium will be established:

 

The result of Y=$50 billion is a result of the savings plans of households. If firms output Y by a lesser amount, say to Y=$70 billion, then households will plan to save $14 billion, which is still higher than the investment plans of firms. A new equilibrium will not be reached until the savings plans of households again equal the investment plans of firms. There is a multiplier effect in evidence here: A change of $10 billion in the savings plans of households has caused a change of $50 billion in GNP.

 The motives for households to save and for firms to invest are quite different. Households save so that they can buy expensive goods in the future, or to protect against becoming unemployed, or to leave wealth for their children, or through sheer miserliness. Firms invest in the expectation of profits, and the volume of investment is clearly a function of the availability of profitable investment opportunities. But even when investment opportunities are poor, households will still wish to save. Because of these divergent motives, there is no guarantee that the plans of savers and investors will be consistent, even in the short run with which this model is concerned. For this reason, the level of national income realized can and does depart from full employment income.

Output and Inflation, Inflationary Bias, Properties of the Phillips Curve

 Output and Inflation

 Aggregate demand determines the actual output of goods and services produced. Given a fixed potential output for any short-term period, aggregate demand will thus determine the unemployment rate. In the simple model used above, when aggregate demand exceeds potential output, an inflationary gap exists and the price level rises. However, in the real world, inflation occurs at or below full employment.

 The inflation rate for a given time period is the per year change in price level: INF_T = (P_T+1-P_T)/P_T. The price level represents the overall price of all goods and services taken together. The most commonly cited measure of the average price level is the Consumer Price Index (CPI). This provides an index of typical consumer products purchased by average households. However, it does not take into account the roughly one-third of total output represented by investment expenditure. The price level index which includes all goods and services in the economy is called the GDP deflator.

 Most firms set their prices based on the anticipated costs of production and the anticipated demand for the goods and services produced. These expectations are based on past performance, economic indicators, and the thought processes of managers. The most recent level of aggregate demand is one of the key factors determining these expectations. The higher aggregate demand, the higher the firm’s own recent demand is likely to have been, and the higher its expectations of future demand. In addition, the higher the aggregate demand, the higher the firm’s expectations about the cost of labor, materials and other factor inputs. As a result, the higher recent aggregate demand has been, the higher a firm is likely to set its prices. If all firms operate in this fashion, then the rate of increase of the price level will be directly and positively related to the level of aggregate demand.

 In any short run period, therefore, aggregate demand will influence both the unemployment rate and the inflation rate. As a result, there will be an implied relationship between unemployment and inflation. For each possible level of aggregate demand, there will be corresponding rate of unemployment and of inflation. The graph of unemployment against inflation for a varying level of aggregate demand in the short run is called a Phillps Curve:

In the real world, the constraint that Y cannot exceed Q is somewhat relaxed, because of the way we have defined full employment. Facing demand exceeding Q, some fatories and workers can work overtime and the average frictional and structural rates of unemployment will fall because there are so many unfilled vacancies.  Thus the economy in the short run can ‘squeeze’ some extra production out of its resources. However, the cost of this economic ‘boom’ is that factor prices will rise and consequently the price level will rise at a rate higher than normal. This is represented by the increasing slope of the Phillips Curve as unemployment goes above U_F.

 One might expect inflation at full employment to be zero, because at over-full employment, scarcity of factors of production will lead to rising demand and thus rising prices; at under-full employment, abundance of factors of production will lead to reduced demand and thus reduced prices; and at exact full employment, demand and supply will be in equilibrium, resulting in stable prices. Empirically, however, the position of the Phillips Curve has been such that some positive rate of inflation occurs at the full emploment rate of unemployment. This is caled the inflationary bias.

 Inflationary Bias

 The labor market is quantitatively the most important factor of production, since it accounts for roughly two-thirds of all income payments by firms. The ‘labor market’ is in fact many different markets, as workers are specialized in many different skills. At any given time, there will probably be some skills that have excess demand while other skills have excess supply. All these markets operate imperfectly, in the sense that wages do not adjust immediately to equate supply and demand. This is particularly evident in many markets where there is excess supply; wage rates are observed not to respond to the downward pressure. Wage rates appear to be ‘sticky’ in the face of high unemployment.

 Many reasons are given for this observation. One is that in many labor markets, wages are determined by collective bargaining between unions and management, sometimes for an entire industry. The political nature of union decision-making is such that a reduction in wages is exceedingly difficult to obtain, regardless of economic circumstances. A reduction in wages makes everyone somewhat worse off. However, a failure to reduce wages makes certain people (those laid off) much worse off, to the benefit of others (those who keep their jobs). If the economic downturn is anything short of catastrophic, less than half the workers are likely to be laid off. If the workers have a good idea who will be axed, then the majority of workers, voting in their own self-interest, will elect to keep their current wages. In addition, those workers with the most seniority are the least likely to be laid off, therefore the most likely to oppose wage reductions—but this group of people are also likely to hold the most influential positions within the union. Another explanation is that given that the government will pay unemployment benefits for a while, a typical worker may be better off accepting work at a high wage in the knowledge that there will be occasional layoffs, than accepting work at a lower wage that continues indefinitely.

 This rigidity does not occur in the upwards direction. Workers are always generally happy to accept more money. As discussed previously, full employment does not mean zero unemployment. It is still possible (even likely) that under full employment, some labor markets will have excess demand while others will have excess supply. In markets with excess demand, wages can be expected to rise relatively quickly, but in markets with excess supply, wages will only fall slowly, if at all. Firms which face excess demand for labor will expect their costs to rise and will therefore set higher prices. However, firms which face excess supply of labor will not have a reasonable expectation of falling costs, and will therefore leave prices unchanged. This will result in an increase in the average price level.

 If unemployment rates are high enough, the downward pressure on wages will be sufficient to overcome downward wage rigidity and wages and prices will fall. There have been very few occasions where this has occurred; the most striking example is the Great Depression in the 1930s, where, in the face of extremely high unemployment rates, the inflation rate was negative for several years on many countries.

 Properties of the Phillips Curve

 The Phillips Curve has another important property: It is not linear. Its curvature suggests that the nature of the trade-off between inflation and unemployment depends on where the economy currently falls on the curve. At high rates of unemployment, the curve is relatively flat: It takes a large increase in unemployment to effect a small increase in inflation. At lower rates of unemployment, a small change in unemployment will result in a much larger change in inflation.

 This can be explained as follows: If the initial condition is high unemployment, then most labor markets will be characterized by excess supply and very few by excess demand. If unemployment increases, the excess demand in those few markets will be reduced, so those few firms will still increase their prices but not by as much as they would have otherwise. However, the downward rigidity of the labor markets already experiencing excess supply will be such that the firms operating in those markets will not change their prices. As a result, the change in the rate of inflation will be small. However, if the initial condition is very low unemployment, most labor markets will be characterized by excess demand and very few by excess supply. If unemployment increases, the upward pressure on wages will be decreased, perhaps sharply in those cases where the initial excess demand was severe. Since very few labor markets were in excess supply conditions, most firms will still expect an increase in labor costs, but less (possibly much less) than previously. As a result, price increases for the majority of firms will be less than they would have been, and there will be some firms which might otherwise have set very sharp price increases who no longer need to do so. The reduction in the rate of incrase of the average price level will be very noticeable.

 The existence of a Phillips Curve causes a problem for government policymakers. A choice must be made between the evils of unemployment and of inflation. Policy tools that affect aggregate demand cannot be used to fight inflation and unemployment at the same time. If aggregate demand is controlled to achieve full employment, some inflation will generally result. If aggregate demand is controlled to eliminate inflation, high unemployment will generally result.

Employment vs. Inflation in the Long Run

 The Phillips Curve is a short run relationship. In the long run, the Phillips Curve can shift its position and change its curvature. Thus, the rate of inflation in the long run depends not only on where on the Phillips Curve the economy is operating, but also where the Phillips Curve is positioned. The fact that the Phillips Curve can shift over time causes some difficulty in interpreting historical data, because it is hard to know whether any given change reflects a shift in or a movement along the Phillips Curve. A moving Phillips Curve can result in a situation where unemployment and inflation move in the same direction. This has caused some to conclude that there is no Phillips Curve. It is important to remember that the Phillips Curve is a short run relationship.

 However, short-run decisions should not be made in the absence of consideration of their long-run impacts. It might be possible, in normal situations, that high unemployment and low inflation today might permit preferred combinations of unemployment and inflation that would not have been possible otherwise. In such situations, the appropriate sort-term policy goal might be to choose an aggregate demand target below potential output.

Demand Deficient Unemployment

 Once all the factors causing ‘full employment unemployment’ are taken into account, any additional unemployment left over must be the result of too little aggregate demand. This is called demand deficient unemployment. Demand deficient unemployment occurs when the number of people unemployed (U) is greater than the number of unfilled job vacancies (V). If accurate values could be determined for U and V, full employment could be defined as occuring when V >= U. Unfortunately, even though reasonably good unemployment data exists, the number of job vacancies is difficult to determine—many job vacancies are never advertised, and sometimes managers may even disagree over whether a particular vacancy exists or not! For this reason, full employment is usually taken to be some set target  rate of unemployment. The full employment rate of employment varies over time for any one country and varies substantially between countries.

 If we know that the economy is operating at full employment, then actual (Y) and potential (Q) output will be equal. When this occurs, we can measure the potential output of the economy. It also follows that the larger the gap between Y and Q, the higher will be unemployment. The output gap, as a percentage, is equal to (Q-Y)/Q x 100. Arthur Okun has conducted research on the empirical relationship between the unemployment rate and the output gap and has found a stable relationship for a 25-year period in the U.S. economy, starting in the late 1940s, with the following equation, known as Okun’s Law:

 

In other words, for each 3% that actual output falls short of potential output, the unemployment rate will exceed the full employment rate by 1%. So if Y is 12% below Q, U will be 4% above U_F. Looking at it another way, Okun’s Law states that for every 1% additional unemployment, 3% of potential output is lost and gone forever.

 Since Okun’s Law was formulated in 1962, further empirical evidence has suggested that the parameter value of 1/3 is not immutable. However, the law provides a reasonable measurement of the loss in real output attributable to demand deficient unemployment.

 

Factors Determining Unemployment

 The most important factors determining the level of frictional, structural and seasonal unemployment are:

Level of Economic Activity – When actual output is close to potential output, employers will face a competitive labor market. Employers will be more likely to advertise and to spend on recruiting. Employers will also likely offer better retraining programs and relocation assistance. These measures will reduce structural unemployment. When unemployment is high, companies will have an easier time finding employees to hire and will be less willing to pay for this type of program.

Transmission of Information – Jobs cannot be filled unless job-seekers can find out about openings and hiring managers can find out about candidates. The more effectively the information is transferred, the lower frictional (and to some extent structural) unemployment will be.

Structural Change – The overall composition of the goods produced by an economy changes with time, as tastes change, new products are invented, world trade patterns move production of particular goods between different nations, etc. Sometimes it changes quickly, sometimes slowly. If structural change is occuring at a rapid pace, the number of people unemployed due to having the wrong skills or living in the wrong location will tend to be higher.

Workforce Mobility – The easier it is to change location, and the easier it is to gain training in new fields, the lower structural unemployment will be. This will depend on factors such as the cost and availability of training, the cost of travel and moving expenses, the degree to which appropriate schools and hospitals are universally available, and so forth.

Institutional Restrictions and Barriers – Governments, trade unions and even employers will sometimes take actions designed to protect particular groups of workers. These actions reduce the efficiency of the labor market and lead to additional structural and frictional unemployment. Examples: restrictive union practices, required professional certifications, pension and medical plans tied to the job, or even local policies which favor existing residents over new arrivals.

Seasonal Industries – Some industries are seasonal by nature: Fishing, farming, forestry, tourism, construction. Despite the fact that predictable unemployment will occur in some periods of the yearly cycle, some economies have clear natural advantages in these industries and find it worthwhile to pursue them.

Potential Output in the Short Run, Potential Output in the Long Run

 If we could take a snapshot of the economy at a specific point in time, it would be possible to enumerate all available resources, both capital and labor, and calculate the maximum possible output if all resources were put to their most productive use. This is the potential output of the economy.

 If sufficient time, energy and resources were applied, the available human and capital resources of a nation can always be increased. In addition, more productive uses of resources can be devised (technological advancement). However, in the short run, it is reasonable to assume that these factors are fixed; i.e. potential ouptut is constant. Thus it follows that there must be a fixed upper limit to the amount of production possible. This leaves open the question of which products compose the potential output. In a two-good economy producing guns and butter (where guns symbolize military spending and butter symbolizes peaceful spending), if the economy is operating at potential output, it is only possible to produce more guns by producing less butter and vice versa. This creates a range of production possibilities at potential output. Any combination lower than potential output is possible, so this curve is a ‘frontier’ that shows the boundary above which additional production is not possible.

 

This graph can be shown to illustrate the microeconomic question of what to produce. At the point X on the graph, the production of B2-B1 additional butter requires the sacrifice (opportunity cost) of the production of G1-G2 additional guns. The opportunity cost is determined by the slope of the production possibility frontier. When society is operating at some point within but not on the frontier, it is possible to produce additional units of one or both goods with no sacrifice to production of the other good; ie, no opportunity cost. An economically rational society will therefore always desire to operate on the frontier.

 

The situation when attempting to decide if more of one good should be produced is different depending on whether society is on the production possibilities frontier. If the economy is currently operating below the frontier, then any decision to produce more of one good can be taken in the absence of information about other goods. However, if the economy is at the frontier, the decision must also include the opportinity cost of output foregone in the other good. The first major macroeconomic question is therefore whether or not the economy is operating on the frontier.

 A point like Z represents a situation that has been experienced from time to time by all major capitalist economies, for example during the Great Depression of the 1930s. Clearly it would be preferable to operate at point X or Y than at Z. There must be highly compelling reasons if a government enacts policies designed to keep the economy at point Z.

 Potential Output in the Long Run

 In the long run, the quantity and quality of labor and capital stock is not fixed; neither is the state of technological advancement. Certain items are relatively fixed over time, such as the amount of land area available. The supply of labor is heavily dependent on the population and its age structure, and by social customs like the common retirement age, the number of hours worked per week, the extent to which people participate in the labor force, and so forth. These are demographic features that change only slowly. Other items can change relatively rapidly in the long run, such as the number and type of factories operational, improvements in technology, and the training of particular segments of the workforce.

 The second major macroeconomic question is: What determines the rate of growth of potential output through time?

 The ultimate objective of economic activity is consumption, which is the present enjoyment of material goods and services. If a society uses all available resources to satisfy present consumption, then no further resources will be available to countract the inevitable decline in productivity of existing capital and labor as machinery gets older and requires more maintenance, as training is not renewed so professional skills diminish, etc. Some level of expenditure on capital goods is required simply to maintain the current level of potential output. If more than this is spent, then potential output will increase. Net investment is equal to the total spent on capital goods, less the amount required simply to maintain current levels. A production possibilities frontier exists between capital formation and current consumption, similar to the one shown above with guns and butter. In order to maintain or increase productive capacity, society must operate at a point on the graph (presumably on the frontier) which is above the replacement investment level on the vertical axis. The vertical distance between this line and the actual operating level will determine the net gain or loss in potential output over time.

 Small differences in growth rate are of substantial importance to the material standards of living. At a growth rate of 2%, standards of living double every 35 years, but at 4% they double every 18 years. The rule of thumb to get the number of years between doublings is to divide 70 by the growth rate.

Aggregate Demand

 GNP is purchased by four groups. The sume of the expenditure of the four groups is known as aggregate demand. The four groups are:

·         Consumers (households)

·         Firms

·         Government

·         International (foreign households, firms and governments)

 This is represented by the equation: Y = C + I + G + X – Z, where:

-          Y = aggregate demand, aka GNP, GNI, GNE

-          C = consumption expenditure

-          I = investment expenditure

-          X = production of export goods

-          Z = expenditure on import goods

Balance of Payments

 A nation’s balance of payments is a complex set of accounts. There are three major accounts involved:

 ·         Current Account (aka Trade Account): Imports and exports of goods and services.

·         Capital Account: Records all trades which affect the amount of claims the nation has abroad, both for and against. Or in other words, all borrowing and lending activity.

·         Official Settlements Account: Records the changes in currency reserves held in all foreign currencies.

 These three accounts sum to zero. The total import and export activity, plus the net effect of borrowing and lending, must equal the change in currency reserves. The term “balance of trade deficit” refers to the current account, and the term “balance of payments defecit” refers to the capital account. A balance of payments defecit can be thought of as the excess supply of a country’s currency—this is the amount of foreign currency that the government must buy if the exchange rate is to be preserved. If the government does not act, a defecit in this account will result in a currency devaluation.

 The total value of world trade is more than 3 trillion dollars a year, but this is a small amount compared to the total value of worldwide currency trading. If currencly fluctuations only occurred as a result of trade, currencies would be quite stable. However, currencies are not stable, because fluctuations also occur due to currency trading that has nothing to do with goods or services trading. For example, if our interest rates are higher than another nation’s, then citizens (and fund managers) in the other nation can improve their returns by buying our currency. Expectations about the future appreciation or depreciation of our currency will also make it more or less attractive to buy. As a result, it is very difficult to predict how exchange rates will change with time. Note that the supply of our currency will affect these expectations and so the supply and demand of our currency are not entirely independent.

Foreign Exchange

 When an individual in one country wants to buy products from another, they must first buy some of the currency of the other country. The exchange rate between country A and country B (in a two-country model) is the same as a price in any competitive market. The demand curve for A’s currency is determined by the people who want to buy products produced by A, and the supply curve is determined by the people from A who want to buy products produced in B. As the exchange rate fluctuates, goods produced in country A will seem more or less expensive to residents of country B and vice versa, altering the quantity demanded and supplied. This is called a flexible exchange rate.

 Some countries adhere to a fixed exchange rate policy, under which the governments of the nations involved agree to buy or sell enough of the currencies involved to keep the exchange rate at an agreed-upon value. The governments involved must add or subtract to demand and supply by amounts just sufficient to push the intersection to the price point desired. This involves adding to or subtracting from a currency reserves account, which will eventually run out of money. So fixed exchange rates cannot be maintained under all conditions.

 The movement from fixed to flexible exhange rates was actually intended to stabilize prices. Under fixed exchange rate policies, large devaluations and revaluations occurred by when the official exchange rate was altered by government fiat. However, stability has not emerged. This is because the demand for a country’s currency does not depend exclusively on that nation’s exports.

Support for Trade Restrictions

 There are some economically valid arguments in favor of trade restrictions. The major ones are:

 -          Infant Industry: Developing nations need to protect their local industry until it can grow to a scale where it is able to compete internationally.

-          Dumping: Dumping is the practice of selling goods in a foreign market at a price lower than that which prevails in the domestic market. The intent is (presumed to be) to drive domestic producers out of business, after which a price hike can be expected.

-          Countervailing Duties: If goods are produced in a nation where the industry is subsidized, and then sold in a nation where no such subsidy exists, then domestic producers will be at a competitive disadvantage to imports from the subsidizing nation. Where such an imbalance exists, it is acceptable to impose a tariff intended to just equal the advantage provided by the subsidization.

-          Squeaky Wheels: While on average everyone benefits from free trade, individually some people lose badly—because they are laid off, or their business cannot compete, or what have you. It is difficult to build a political organization a large number of small gainers, but it is relatively easy to build a political organization around a small number of big losers; say, unemployed steel workers in Pennsylvania. While theoretically it is possible for the losers to be compensated from the benefits of the gainers, in practice this rarely (if ever) happens.